This piece focuses on a pitfall that can surprise taxpayers who receive rollover equity. Take the situation described below. Then consider the points in the following discussion.
Sale with Rollover Equity
A, an individual, owns 100% of Target. Target is a corporation that A uses to run a business. Buyer offers to buy the business. Buyer wants to keep A involved as an owner and manager. Buyer proposes the following:
- Buyer and A form Newco, an LLC taxed as a partnership.
- Buyer gets a membership interest in Newco in exchange for contributing cash to Newco.
- A gets a membership interest in Newco in exchange for contributing 10% of all the Target stock to Newco.
- A sells the remaining 90% of the Target stock to Newco for the cash that Newco received from Buyer.
Results: Buyer and A are co-owners of Newco. Newco owns 100% of Target. In steps 2 and 3, Buyer and A do not recognize gain or loss when they contribute property to Newco in exchange for membership interests in Newco (under IRC Section 721). In step 4, assuming the value of the Target stock was higher than A’s basis in the stock, A must recognize gain equal to the amount of cash A received minus A’s basis in the Target stock (under IRC Section 1001).
With respect to LLCs taxed as partnerships, the Internal Revenue Code generally permits members to contribute property to, and receive distributions from, an LLC without recognizing gain. See IRC Sections 721 & 731. This is in line with the overall nonrecognition regime governing partnerships under the Internal Revenue Code. For purposes of this discussion, whenever an LLC is mentioned, assume it is an LLC taxed as a partnership.
In transactions involving the sale of a business, the parties often use the nonrecognition provided by Section 721 to give selling parties “rollover equity.” The selling parties receive an equity interest in the acquiring company in exchange for a portion of the equity interests that the selling parties had in the target company. If the acquiring company is an LLC, IRC Section 721 says this exchange is not a taxable event.
There are at least two prevalent reasons why rollover equity is used: (1) the rollover element reduces the overall tax owed by the selling parties, and (2) having the selling parties continue their ownership interest in the enterprise incentivizes them to keep working to make the business successful after the transaction.
In the sale described above, A likes that step 3 is a nonrecognition event. Say, for example, A is the sole founder of Target’s business, and therefore has a $0 basis in the Target stock. A has built Target’s value to $10 million. The fact that A could roll over A’s 10% interest in Target (worth $1 million) in a nontaxable exchange saved A $200,000 in taxes, which A would have owed if A had instead sold the 10% interest for cash (assuming a long-term capital gains tax rate of 20%, multiplied by the amount realized of $1 million). Also, as a partial owner of Newco, A will want to keep working to grow Newco’s value.
Before the transaction described above, A’s advisers told A (correctly) that A’s receipt of a membership interest in Newco would be a nontaxable event. After the transaction, when A receives distributions from Newco, the nonrecognition treatment of IRC Section 721 will not apply. When Newco earns income through its operations, and then distributes some of that to A, A is generally taxed according to the rules described below under “Operating Distributions.” If Newco makes a payment to A of cash not generated through operations, A needs to be careful. This is because several provisions of the Internal Revenue Code trigger gain recognition by recharacterizing what might otherwise appear to be a “distribution.” The discussion under “Non-Operating Distributions” below deals with these considerations.
Under IRC Section 731, a member of an LLC recognizes gain only if the member receives cash in excess of the member’s basis in the member’s interest in the LLC. Under IRC 705 a member increases the member’s basis in the member’s membership interest to reflect income that was allocated to the member by the LLC. Under IRC Section 722, a contributing member to an LLC takes as the member’s basis in the LLC interest received an amount equal to the sum of the adjusted basis the member had in any contributed property, plus any cash contributed.
So in the transaction described above, because A had a $0 basis in the Target stock that A contributed to Newco, A took a $0 basis in the Newco membership interest that A received (Section 722). Assume the transaction involving Newco closed on December 31, 2020. If Newco earns $100 in 2021, and $10 of that income is allocated to A, A will owe tax on that $10 of income. That increases A’s basis in A’s membership interest from $0 to $10 (Section 705). In 2022, if Newco distributes $10 to A, A will not owe tax on that distribution because A had a $10 basis (Section 731). Upon the distribution of the $10 to A, A’s $10 basis drops to $0 (Section 733).
Suppose Buyer and A have big plans for Newco and, shortly after the transaction in which Newco acquires Target, Buyer and A cause Newco to take out a $10 million recourse loan. This increases Buyer’s and A’s aggregate basis in their membership interests by $10 million (Section 752(a)). A’s own basis in A’s membership interest goes from $0 to $1 million.
Recall that, under IRC Section 731, an LLC member recognizes gain on a distribution only if the member receives cash in excess of the member’s basis in the member’s interest in the LLC. Now that A’s basis in A’s membership interest is $1 million, and Newco has $10 million in cash (loan proceeds), Newco can distribute $1 million to A, and A arguably does not need to recognize income (Section 731). In a similar situation, a taxpayer successfully received cash without recognizing gain in Otey v. Commissioner, 634 F.2d 1046 (6 th Cir. 1980).
After Otey, Congress enacted IRC Section 707(a)(2)(B), which attacks this type of transaction. The thinking is that a contribution of property to a partnership, together with a related distribution to the same partner, should be characterized as a sale or exchange of the contributed property. This would treat A’s contribution of the 10% of the Target stock to Newco, followed by a distribution of $1 million to A, as a taxable sale of the Target stock.
How can A avoid the application of Section 707(a)(2)(B)? In many cases, waiting 2 years will work. Treasury Regulation Section 1.707-3(d) creates a presumption that transfers separated by more than 2 years are not sales. The rationale: If A’s 10% stake in Target is at risk in Newco’s business for a sufficient time, then A should get nonrecognition treatment.
How about transfers that look like operating distributions, like the $10 A gets from Newco in 2022 (described above under “Operating Distributions”)? Could Section 707(a)(2)(B) recharacterize such a distribution as a partial sale of the 10% of the Target stock that A had contributed to Newco upon Newco’s formation? Perhaps. How can A avoid the application of Section 707(a)(2)(B) with respect to such payments? Treasury Regulation Section 1.707-4(b) enables an LLC to make normal distributions out of operating cash flow without triggering Section 707(a)(2)(B).
If you receive rollover equity in the sale of a business, waiting 2 years before receiving a significant non-operating distribution from the entity that issued your rollover equity may be a good idea, for the reasons discussed above. Note, however, that the IRS can nevertheless try to rebut the presumption offered by Treasury Regulation Section 1.707-3(d) (see a list, in Treasury Regulation Section 1.707-3(b)(2), of 10 facts and circumstances that tend to show that a sale occurred).
Even if you get comfortable that you are clear of IRC Section 707(a)(2)(B), keep in mind the “mixing bowl” rules of IRC Sections 704(c)(1)(B) and 737, which can trigger gain to the contributing partner (A in our example above). Section 704(c)(1)(B) triggers gain recognition where property (other than cash) is distributed to a partner other than the contributing partner within 7 years of the original contribution (say, in the example above, Newco distributes Target stock to Buyer). Section 737 triggers gain recognition if, within 7 years of a contribution, the contributing partner receives a distribution of property (other than cash) that is not the property that the contributing partner originally contributed (say, in the example above, Newco distributes marketable securities or real property to A).
Author: Andrew D. McCarthy, attorney at Weintraub Tobin Chediak Coleman Grodin Law Corporation
This e-bulletin was submitted with permission by the author by Chris Chediak, Esq., attorney at Weintraub Tobin Chediak Coleman Grodin Law Corporation, firstname.lastname@example.org.